Ascendance of the Pod Masters

Multi-manager, multi-strategy hedge fund platforms (also known as “pod shops”) are receiving a lot of attention these days from asset owners, the media, and asset managers who compete with them.  Good performance, huge paydays, and perceived scarcity will do that.

As with every episode like this, one has to ask how far and how fast the trend will go — and whether heightened expectations, bigger pools of assets, and more favorable terms (for the managers) will sow the seeds of disappointment to come (for investors).

A superior approach?

In brief, the fund platforms aggregate money and then dole it out to scores, even hundreds, of portfolio management teams — the pods.  Each has a defined strategy and risk limits in which it operates.  Assets are allocated to the pods based upon the desired mix of exposures for the fund overall and on recent performance.

In a sense the “human capital” is rented and disposable in a way that is unusual at most asset management organizations.  (It is somewhat akin to how big investment banks work, where specialized trading desks or entire businesses can spring up or go away quickly depending on what’s hot and what’s not.)  The composition of the investment team, if you want to call it that, can change in meaningful ways in a short period of time, something that would normally turn off asset owners.

So the organization really boils down to its leadership and the framework that exists to add and subtract those moving parts, to provide the operating environment and the risk management to monitor them, and to allocate assets.

Is it a superior approach?  Can (and should) it be adopted in other parts of the investment business?

Strong demand

As noted in a good Bloomberg article by Nishant Kumar, “Almost all the new money in hedge funds is going to giant multi-strategy investments.”  As ever, performance has driven the flows, as the big firms structured in this way have delivered steady (if not spectacular) numbers over many years, with small drawdowns and moderate correlations to equities.  Those results and the “emphasis on rigor” in pulling capital away from underperforming pods,

appeals to pension funds, foundations and endowments that have gravitated toward hedge funds, often without the resources to closely track what each manager’s doing.  When the rest of the investment community opts for diversified multi-strats, why get on the rollercoaster with a rockstar?

Those investors (and ones not mentioned) are eager to add more money to the few firms that fit the bill.  No doubt other asset managers will try to meet the demand by copying the category leaders, but they will struggle to compete with the incumbents, which are of a size and profitability that they can continue to invest (in systems and pod talent) and innovate (as Citadel has done with weather-related strategies) to stay ahead of the crowd.

Risks

Which is not to say that there aren’t risks involved in investing with them.

Regime shifts ~ While the firms have demonstrated the ability to adjust quickly to new environments, changes in established relationships and correlations (which we’ve had quite a number of in the last few years) present opportunities to stumble.  Market history is replete with examples of expectations based on statistics and trends going awry.

Scale ~ Those shifts can be most painful after a period of success, when the assets of an individual firm or a group of like funds chasing a winning approach get too large and the pile of assets under management becomes unwieldy.

Leverage ~ Returns are better with leverage until they’re not — and those willing to supply that leverage have shown time and again that they aren’t very good at pulling it back in advance of problems developing.  How likely are they to turn down the opportunity for more business with these headline-grabbing managers?

Put these three things together and you have to wonder about the scenario brought up by Will Potts in the Bloomberg article:

Could you imagine the Fed allowing a $50 billion multi-strategy hedge fund to fail?  I can’t.  Think about the pain that Archegos caused and that was tiny in comparison.  The damage that would be done to the prime brokers would cause financial distortions, it would be LTCM on speed.

And there is the “war for talent” which the success of the platforms is engendering.  (Among the many reports of that phenomenon, see “The State of our Union 2023: RESET,” from Jefferies, and articles in the New York Times recently and the Financial Times in late 2021.)  At what point does paying a lot for talent become paying too much for talent?

The view from the pods

The chief beneficiaries of that war for talent are the people who can get enormous up-front guarantees, but everyone who stays in the pod system benefits from the largesse.

There are other advantages to being a pod person rather than taking the traditional route of hanging out your shingle as the leader of a startup.  You don’t have to deal with the hassles of regulatory requirements or operations or marketing or investor relations — and maybe you’ll be able to attract a better team around you at a pod shop than if you were running your own firm.

You can get on to the business of investing, and do so faster and in a bigger way, as Andrew Beer told Bloomberg:

Joining a multi-strat on Monday and having $500 million to punt around on Tuesday is a hell of lot more appealing than scrounging for $50 million of seed capital to start your own firm.

There is a flip side, of course.  You are now the rented and disposable human capital previously described.  All of the advantages cited above can go away in a hurry.

Bloomberg again:

Multi-strats, meanwhile, have a low tolerance for underperformance.  With individual managers less visible to clients, those who start losing in high single digits or overextend their risk can have their assets cut at best, and at worst can be fired on the spot.

It’s not unusual to see a tweet from someone on the wrong end of the whip who was blown out for their individual work or because their whole pod was jettisoned.  Many me-too comments from others in response commiserate about similar experiences and life in the pod jungle.

As mentioned before, that’s a different look than what you’ll find in many parts of the business, although it apparently doesn’t stop firms from talking about the strength of the teams they assemble as if they are the key to their long-term success.  For example, this is from Citadel’s website:

To maximize our impact, we’ve built a team-first culture that always seeks a better idea — then works to make it a reality.  Working and learning together, we create new solutions that reveal market opportunities.

According to published reports, during a few months in 2021, 13 of 27 portfolio managers at Citadel’s Surveyor unit were axed, while ten new ones joined, a level of turnover that seems to not fit very well with the narrative.

Fees and other terms

A recent posting on this site asked the question, “Are hedge funds aligned with their investors?”  Certainly the question applies to these platforms, since they have been the most aggressive in pushing for higher fees and other favorable terms, especially when it comes to passing through the expenses of their operations to their investors.

That’s how the war for talent translates into costs for investors.  Historically, hedge funds charged 2% a year on account balances and 20% of the total return produced in a year (with a high-water mark in place so that a performance fee isn’t earned until a drawdown is recouped).  The AIMA report cited in the previous posting documents the declines over time in the average levels for each of those fees — until recently, when they ticked up, driven by the multi-strategy platforms.

The report also addresses the pass-through fees, which can turn a 2% fee on assets (when the managers are paying the operating expenses themselves) into an effective fee of 6-10% or more, according to published estimates.  Given that war for talent, those numbers may be going even higher, illustrating why firms are willing to so aggressively wage that war.  Someone else is paying for it.

Some of the firms also charge performance fees that are notably higher than 20% and, increasingly, lockups of investor capital for five or ten years are part of the deal too.

Alignment issues everywhere you look.

It has long been a part of the pitch from the managers of hedge funds — and those who favor investing in them — that the size of the fees doesn’t matter, that it’s the net return that does.

But in most areas of the investment world, higher fees are generally correlated with worse performance.  Net return is an aspirational concept.  Fees, on the other hand, are going to get charged no matter what (although the pass-through approach has made pinning down the amount of them more difficult).  So high fees can matter for the future, even if they haven’t seemed to in the past.

However, another Bloomberg article, “Hedge Funds That Charge Most Tend to Perform Best, Barclays Study Shows,” provides some (limited) ammunition for the net-return case.  Of 290 funds, the worst performance was for those funds without any pass-through fees.  Those with partial pass-throughs did much better, and the ones with a full pass-through of fees topped them all.  The time period was only three and a half years, but that was enough for Roark Stahler of Barclays to say:

Established multi-strategy managers, with a strong brand, have the ability to hire the best talent, purchase the most data and invest in infrastructure.  Those costs are passed on to the investor, which benefits the firm, but also shows investors should be OK paying that because they’re still getting better returns even after those fees.

Ecosystem effects

Any trend like this causes ripple effects in the investment ecosystem.  That war for talent is a big one, increasing costs for hedge fund firms that don’t pass expenses along, as well as for other asset managers whose analysts and portfolio managers are at risk of getting poached.

As assets increase at the platforms, certain strategies might get more competitive, putting previously assumed alpha at risk.  There will likely be fewer emerging managers — and a more challenging fundraising environment for those that do give it a go, since their survivability may be viewed as less likely.

A Financial Times piece from Robin Wigglesworth considers the prospects of “DIY multi-strategy hedge funds,” while asking the question, “What could possibly go wrong?”  It references the Jefferies report cited earlier, which says

that some investors (probably bigger and hopefully more sophisticated ones) are now basically setting up DIY multi-managers by making SMA investments in a bunch of smaller, specialised hedge fund managers.

But Wigglesworth writes that it’s “easy to see how this can go catastrophically wrong”:

Managing a DIY multistrat fund through SMAs must be phenomenally complicated, and require a level of sophisticated risk management and tactical capital allocation that’s beyond most institutional investors.

On another front, for those wearing due diligence hats, the challenge will be trying to understand how the platforms work when there is limited visibility into them.  Especially since your co-workers and clients/stakeholders may be pushing you for opinions on them (and often wanting to hear particular answers).

For starters:  How are decisions made at the strategic level?  What is the role of qualitative analysis versus quantitative analysis in the allocation process?  What does risk management entail besides clipping the wings of underperformers?  How are teams selected?  What kinds of resources are they given?  Is there any attempt at developing them, or is it just survival of the fittest?  Is any information shared between them or are they walled off from each other?  (Speaking of information, how can the potential use of inside information, which is arguably more probable in this kind of firm, be monitored and prohibited?)

And, a fundamental question for asset owners:  Is there an imaginative approach to analyzing these organizations and the pods that comprise them or is the “work” going to consist mostly of an evaluation of performance?

Next steps

Existing investors in the pod shops no doubt are pleased with the performance that they’ve received and with the emotional satisfaction of “being in on” the most talked-about (and written-about) strategy around.

It seems that only one thing will break that allegiance now; investors quoted in articles about the firms say they will stay the course as long as the outperformance continues.  According to the AIMA report, despite the tougher terms from the multi-manager firms, clients “are prepared to accept [them] provided that the same managers continue to deliver performance that meets their expectations.”

The rest of us might want to think about whether we would invest with the pod masters if given the chance to do so; whether their methods should cause us to rethink how organizations are structured and strategies are managed; and what the broader implications of this industry development might be.

Published: March 18, 2023

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Investor Identities, Availability Cascades, and Unknown Unknowns

How is your R&D coming along?

First the pandemic, then a difficult 2022, and now, suddenly, concerns about some parts of the banking system.  It has seemed like (well) everything, everywhere, all at once.

In environments like those, time horizons shorten, perspectives narrow, and innovation efforts are put on hold, sacrificing long-term opportunities to fight the fires of today.

All investment organizations need R&D efforts that span several dimensions, as outlined here.

Don’t bank on it

In the last three trading days, your inboxes have become stuffed with reporting, knee-jerk analysis, trade ideas, and political and economic commentary about a banking crisis that wasn’t even on your radar screen before that.  Rather than pick what seem to be some of the best pieces during a period of rapid change, we’ll let the dust settle a little.

It is a good time to see the narrative process in action.  The first reaction by many market participants is to interpret the events based upon their existing world view — that comes naturally to all of us.  But there have been some notable flip-flops, as indicated by John Thornhill’s opinion piece in the Financial Times:

Like banking titans in 2008, tech tycoons favour the privatisation of profits and the socialisation of losses.

There are arguments about language:  Are these bailouts or not?  What do we call this spasm?  Is it a banking crisis or something else?

Yet to be seen are the ripple effects from the unwinding of some of the concentrated web of venture capital relationships at Silicon Valley Bank, as well as the interest rate risks that had grown large there and at some other banks.  On both fronts we’ve seen another chapter in the ongoing saga of analysis and risk management taking a back seat — or rather being tied up in the trunk — while business momentum drives decision making.

Since the close on Wednesday, the yield on the two-year U.S. Treasury has dropped more than one percent.  Is that a reason to cheer or to worry?  For one thing, such a sharp reversal after a prolonged move higher probably caused some large losses for some levered strategies.

Investor identities

Ashby Monk and Dane Rook continue their work on the analysis of institutional investors in “The ‘Investor Identity’: The Ultimate Driver of Returns” (available on SSRN).  They stress the differences across those investors (who are often lumped together and whose results are compared to each other), based upon their particular sponsors, geographic locations, resources, capabilities, and histories.  There is no one best approach, just better choices under particular circumstances.

The authors offer a framework within which the production of investment returns is a function of capital, people, processes, and information.  Three “enablers” improve those inputs:  governance, culture, and technology.  And then there’s innovation, “a direct function of how those seven elements work in conjunction.”

This structure is used to outline five “mini-cases” that speak to the differences in often-cited approaches, four of which are known by prominent pioneers of them: the Yale, Canadian, Norway, and Australian models.  A fifth, the “collaborative model,” rounds out the group.

Unlocking value

A paper from FCLTGlobal, “Unlocking Value by Targeting Long-term Shareholders,” says that “attracting the right shareholders can make or break a long-term corporate strategy.”  It argues for changes in how companies present themselves to the market, including eschewing the typical playbook for sell-side interactions and earnings calls, which primarily feed the needs of traders rather than investors.  Companies should:

Target long-term shareholders strategically.

Engage with their large, long-term shareholders, not with the “investment community.”

Reward IR professionals for long-term shareholder success.

Other reads

“On Availability Cascades,” Marc Andreesen.  While reading through this excellent piece, think about how investment market participants also try to spark and fan the flames of cascades that are in their interests.

What is the purpose of activists, experts, professors, nonprofits, and various other kinds of pressure groups?  To propose and propagate availability cascades, to put their unique topics front and center in the public consciousness, in hopes of triggering availability bias and sparking availability cascades — and the resulting money and prestige and influence and power.

“Could You Bear Being the Sidekick?” Frederik Gieschen, Neckar.  “Consider how unusual it is for Munger to accept the junior role despite being a brilliant thinker in his own right.”

“Psychological Paths of Least Resistance,” Morgan Housel, Collaborative Fund.

Being honest about the odds that your opinions and forecasts will actually come true can be so discouraging and uncomfortable that the warm blanket of denial and overoptimism becomes home to most people’s beliefs.

“Preparing for the Unknown Unknowns,” Matthew Crow, Mercer Capital.  The proposed purchase of Focus Financial is an interesting case in the RIA M&A scrum; its “partner firms must be wondering if they’ve got the deal they signed up for.”

“Developing a Personal Backstory that Resonates with Clients,” Dan Sondhelm, Sondhelm Partners.  Better ways to respond to a request to “Tell me about yourself” than a list of schools and jobs.

“Fund Managers: Are you prepared for investor due diligence in 2023?” Fiona Sherwood, Dasseti.

It’s not just that there’s an ESG section or a diversity section.  The questions are being peppered right through the DDQ now.  They’re popping up in every different category of questions.

“Adopting behavioral finance in investment management,” Florian Forst, Arthur D. Little.  To tailor their offerings to “the very specific needs of individual customers,” firms “must know what makes their customers tick.”

“Chronicles of an Allocator,” CAIA Association.  Key elements in moving from modern portfolio theory to a total portfolio approach to managing a pool of assets.

“Why Lehman Brothers Failed When It Did,” Joe Pimbley, Stories.Finance.

While numerous factors contributed to Lehman’s demise, the immediate cause was collateral calls by Lehman’s clearing banks, chiefly JPMorgan.

“The diluted EPS calculation is 50 years out of date,” Steve Cooper and Dennis Jullens, The Footnotes Analyst.  The “full economic value . . . is not reflected in financial statements.”

“Morningstar’s Role in Portfolio Framework,” Amy Arnott, Morningstar.  The framework “is designed to help beginning investors avoid unforced errors” by assigning funds (by type) to “a recommended minimum holding period and a maximum position size within a portfolio.”

Finding good ideas

“The way to get good ideas is to get lots of ideas, and throw the bad ones away.” — Linus Pauling.

The private equity debate

This chart is from “Private Equity’s Other Illiquidity Premium,” a Man Group report by John Lidington.  It is used to assert “that 2009 was the last vintage of buyout funds to significantly outperform the passive public equity market on a realised [public market equivalent] basis,” and that missing the 2021 exit window has put the unrealized portions of the more recent vintages in doubt.

The piece offers good perspective on issues of diversification, correlation, volatility, drawdowns, and smoothing techniques.  Worth highlighting advocates for “liquid private equity alternatives” (which Man offers), so it also picks up on previous research by others on PE replication strategies.

While “many investors prefer to have smoothed returns reported to them . . . the question becomes how much of a fee premium should be paid for smoothing.”  Does the “absolutely massive mismatch in the typical fees paid” make sense?  (Even if some of those fees are recycled into asset owner benefits beyond smoothing.)

But the private equity debate is an active one, so here are some perspectives from the other side:  The Bain Global Private Equity Report details the tale of two 2022s (and says that “opportunity awaits firms that stay aggressive”); KKR explains “The Role of Private Equity in the ‘Traditional’ Portfolio” during a time of regime change; and BNP Paribas offers the standard narrative that increased investments in private assets are warranted, “given their potential to enhance returns and reduce risk” — while adding a wrinkle, “and the role they can play in sustainable investing” — in a report titled “Allocating to private assets in open-ended funds.”

Postings

Two recent postings for paid subscribers:

“Are Hedge Funds Aligned with Their Investors?”  A paper based on a recent survey of hedge fund managers prompts questions about the alignment of interests between hedge funds and their investors.

“The Outsourcing Debate: Principles and Rules.”  A proposed SEC rule regarding the outsourcing of capabilities by investment advisory firms shines a light on how they evaluate and select third-party providers.

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.

Published: March 13, 2023

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Are Hedge Funds Aligned with Their Investors?

Here are two paragraphs from the introduction to “In Sync: How hedge funds achieve alignment with investors to foster long-term strategic partnerships,” a piece from the Alternative Investment Management Association (AIMA):

When you strip away the lively discourse around the outsized returns that some alternative investment fund managers can generate, the proactive efforts to align their interests with their investors are arguably the most attractive aspect of their offering.

Every aspect of the GP/LP offering from the fee model and performance incentives to the products offered includes characteristics designed to ensure that when the fund manager does well, the investor does well, and the fund manager only does well when the investor does well.

Before continuing, it is worth reporting that AIMA is “the global representative of the alternative investment industry,” working “to raise media and public awareness of the value of the industry.”  Survey results from 138 fund managers (with an average of $5 billion in assets) are used to buttress the conclusions of the report and further that mission.  The results are some interpretations of “alignment” that investors and independent observers might find questionable — or laughable.

The “fundamentals”

The opening part of the document, titled “Aligning interests: The fundamentals,” begins in this way:

The central pillar for securing a strong alignment of interests between managers and investors remains how much skin they have in the game (i.e., the personal capital invested in the fund by the principals).

While the supporting data was not provided (so the other possible responses could not be viewed):

When asked how they primarily align interests with investors, over three-quarters of fund managers surveyed said it was achieved through having a significant personal investment in their own funds.

A trend toward “broader skin in the game” is discussed — extending ownership beyond the principals as a way to fight the “intensifying war for talent” — and transparency for investors is also examined as a way to provide greater alignment.  As noted, there are positive and negative aspects of more transparency.  (Some managers effectively use greater openness as a selling point.)  The reasons for a given level of transparency ought to be clear to investors, yet often they are not.

The “fundamentals” primer concludes with a section on relationship management which states that “the most important feature for managers seeking to align interests is the desire to create a ‘stickier ticket,’ i.e., create an appealing offering for investors to dissuade them from redeeming their capital.”  Thus, alignment means getting to keep the assets by adding some new attractions, rather than wrestling the elephant in the room.

Fees

Average management fees increased from a similar 2019 survey, driven by managers with over a billion dollars in assets (they went down for smaller managers).  The explanations offered ought to raise some eyebrows:

With costs continuing to rise across the industry (aggravated by a ferocious war for talent, the need to digitise the business, not to mention the relentless pace of regulatory and compliance change), there is a clear sense that a tipping point has been reached regarding the headline fee that fund managers charge to support the operation of their business.  In addition, the strong performance from the industry over the past two years (with hedge funds on average offering the best set of returns over a passive investment/ETFs) has allowed some fund managers to push forward their case to receive higher compensation.

Performance fees were also higher, again because of larger funds, while those on smaller ones declined.  High-water marks continue “to be the dominant mechanism used by investors to help ensure fund managers only get compensated on any net new increases in the fund’s asset value,” although uncommon permutations of them are increasing, including ones that are reset annually or for a multi-year period (rather than continuing perpetually).  Do those indicate greater or lesser alignment with asset owners?

And then there are hurdle rates:

Increasingly, hurdle rates are being considered a prerequisite in any performance compensation arrangements between fund managers and their investors, especially with regard to any new fund launches.

Half of the managers now use hurdle rates, up from a third in 2019.  That would seem to be progress, but “there are many variations to the types of hurdle rates being agreed [on by] fund managers and their investors.”  No data is provided regarding the prevalence of the different kinds of hurdles; it would be instructive to know what types are being used and to what degree (including the faux ones called “soft hurdles”).

This is where the fund-manager-only-does-well-when-the-investor-does-well façade really breaks down.  It is otherwise widely accepted that asset managers should be judged (and rewarded) on whether they outperform a representative index, yet most hedge fund managers continue to be rewarded for beta above a hurdle because of historical precedence.  (It was more defensible years ago, when markets were less efficient.)  Real alignment would look different than that, with some notion of alpha being the appropriate above-hurdle measure.

There are other topics touched upon, including catch-up provisions, clawbacks, and crystallization frequencies.  It’s hard to make the case that the way these provisions are used in the industry provides alignment with the actual owners of the assets.

Preferential terms, tiered management fees, and other forms of “relationship pricing” do offer some improvements under certain conditions, but they work from the general base of misalignment.

(The pass-through of expenses is also covered in the AIMA report.  That will be addressed as part of a subsequent posting on the multi-manager platforms that are currently all the rage.)

Two other short parts of the paper are on product innovation (exclusively looking at co-investment opportunities) and ESG (as evidence of managers “adapting to the changing landscape”).

Context

In surveys where both hedge fund managers and their clients are surveyed, there are large differences in beliefs between them across many of these aspects of purported alignment.  An objective review ought to include both points of view.

Almost all asset owners, even large ones, are price takers when it comes to partnership vehicles, with some exceptions for “relationship pricing.”  Of course, cash flows to hedge funds ebb and flow according to how they are performing (as they do in other product categories).  Many different strategies fall under the hedge fund umbrella, so summarizing performance is hard, but the general progression of mandates and performance over time was accurately characterized by Bob Seawright in an edition of The Better Letter (previously quoted in a Fortnightly):

Gaslighting and poor performance undergird the change in hedge fund marketing over the years.  It went from “We’re going to make a ton of money,” to “We’re going to outperform,” to “We’re going to provide superior risk-adjusted returns,” to “We’re going to provide absolute returns even in down markets,” to “We’re going to provide non-correlated returns.”

Throughout it all, managers (and the AIMA) have been pushing the narrative that hedge funds are uniquely aligned with their investors in ways that lead to superior returns (and getting more aligned over time).  Are they really in sync with investors — or just saying that?

Published: March 12, 2023

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The Outsourcing Debate: Principles and Rules

A proposed rule from the Securities and Exchange Commission would require an investment advisor that wants to outsource part of its responsibilities to conduct “certain due diligence and monitoring of the service provider.”  As is always the case with such rules, there are complexities, including what constitutes a “covered function” that is subject to the rules.

As explored (among other issues) in a previous posting, “We Need Some New Terminology,” the term “investment advisor” is broad, referring to different kinds of organizations.  The implications of the proposed rule will vary by the type of firm, its size, the nature of the services provided to clients, and what is to be outsourced.  For this posting, the focus is not on asset managers, but rather investment advisory firms.

Reaction to the rule

Given that the additional requirements of the rule will translate into higher expenses, there has been a fair amount of pushback in the industry.  An article from Citywire RIA cites some of the objections, including that it is redundant given “an advisor’s existing fiduciary duty to assess service providers;” overly broad definitions and requirements; cybersecurity concerns from disclosure of service providers to the public; and the likelihood of further industry consolidation because of the burden on smaller advisory firms.

An RIABiz posting provides additional comments from industry sources, and references SEC concerns that advisors could “use third parties to address their own expense needs rather than a client’s best interest.”

Scott MacKillop of First Ascent Asset Management, which provides a “turnkey asset management program” (TAMP), penned an opinion piece for Wealth Management, titled “TAMP Users: Get Your House in Order.”  He wrote that the SEC wants advisors to:

Have processes and procedures in place to organize and manage due diligence activities;

Perform a thorough due diligence examination before hiring a covered service provider;

Monitor the selection on an ongoing basis to ensure it continues to benefit clients; and

Keep books and records to document and justify the process.

No doubt he’s hoping that his firm will benefit from the increased scrutiny, as indicated in this section (which nonetheless rings true):

If you’ve been sticking with your current TAMP because you’re a member of its “Old Timers Club,” you like its wholesaler, its conferences are really fun or it helps you with your marketing, guess what . . . You’re in trouble.  None of those factors benefits your clients.

The drive to outsource

An article in the Economist, “How technology is redrawing the boundaries of the firm,” traces theories of outsourcing to the 1937 work of Ronald Coase, who “argued that firms’ boundaries — what to do and what not to do yourself — are determined by how transaction and information costs differ within firms and between them.”  In the investment world there has been a profound shift toward outsourcing as markets have gotten more complex and technology has offered new possibilities.

As perfORM (which does operational due diligence) said in a newsletter regarding asset manager outsourcing, it makes sense “to remove expensive, non-alpha generating functions and outsource them to a scalable third party whose business is to deliver those services expeditiously, cost-effectively, and hassle-free.”  An investment advisory firm has an additional dimension to deal with beyond operations and investment management — its information about its clients and their individual needs.  All three areas provide risks and opportunities when it comes to outsourcing.

Selection and monitoring

In each, it is easy to take selection and monitoring responsibilities too lightly.

Does the advisory firm have people that are sufficiently knowledgeable about the specifics of the area to make good decisions about the outsourcing providers?  Do they have the due diligence skills to go beyond the surface layer of information that has been given to them to identify otherwise unseen risks?  Are they driven by price or (in the case of investment-related decisions) by historical performance?  Is a risk-based evaluation framework in place — and have the apparent positives and potential negatives been laid out in a way that provides a balanced view?  Or are choices made because the provider has been a popular selection by others, so there is the comfort of being with the crowd, even if deep due diligence hasn’t been performed?

Some advisors might be considered experts at all of this (and the required details in the levels below these general questions), but many are not.  That stands to be true whether the principles-based fiduciary standard is viewed as the guiding star or the SEC codifies its rules-based solution.  Firms need to do some self-assessment regarding these issues in either case.

One example

Opening up private investment vehicles to a broader clientele is a hot topic in the industry these days.  Not just the standard “liquid alts” (examined by Larry Siegel in a recent Advisor Perspectives piece) but versions of the private equity, credit, and real estate funds that are so popular with institutions.

Many — probably a large percentage — of advisory firms are ill-prepared for the high-powered marketing effort by the purveyors of those products that is coming their way (or perhaps has already arrived).  The historical performance of those institutional funds will dazzle advisors and clients, some of whom have been pushing for a piece of the action.  The general partners of the funds are looking to “retail” for the next big flow of assets into their coffers and have a well-honed pitch.

Liquid alts turned out to be a bust overall.  Whether illiquid ones will delight or disappoint remains to be seen — will the typical advisory firm be able to properly vet the choices that are presented?

Beyond the rule

While the proposed SEC rule is getting the attention, the general questions behind it are what’s most important.  How good are advisory firms at assessing the trade-offs — for their clients, not themselves — of the range of outsourced services that they are employing?  How well can they judge the quality of those providers?  Does their own circle of competence qualify them to evaluate that of others?

Organizations should want to get better at all of this, whether the rule forces them to do so or not.

Published: March 7, 2023

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Managers, Machines, and the Conveyor Belt of Finance

Coming attractions for paid subscribers will include essays on the hot area of multi-manager platforms, the alignment of interests between general and limited partners, new rules and best practices regarding outsourcing, and the use of natural language processing in investment applications.  Sign up here.

On to the readings.

Asset manager meetings

Joe Wiggins wrote a posting, “Are Fund Manager Meetings a Waste of Time?” in which he points out more than a dozen potential issues with those interactions.

Despite that, here is his conclusion:

Are fund manager meetings a waste of time?  No.  Is it a waste of time or worse if we don’t acknowledge or deal with the behavioural biases that we carry with us into those meetings?  Almost certainly.

(Effective methods for dealing with the challenges Wiggins raises are a key part of the due diligence course in the Academy part of this site.)

Machine learning

In “How Can Machine Learning Advance Quantitative Asset Management?” David Blitz and others from Robeco cover the advantages and disadvantages of using that approach.  As noted in the paper, “finance and investment is ultimately a social science that revolves around human behavior” — and machine learning methods “have shown particular promise in replicating” that behavior.

But there are pitfalls:

ML models are particularly useful for applications with a large amount of data and a high signal-to-noise ratio.  In financial market research, however, the data sets are comparatively small and the signal-to-noise ratio tends to be low.  Moreover, many data points are correlated, both in the time series and in the cross-section, which further reduces the effective number of observations.

The piece provides examples of how the techniques can be used, while stressing that “rigorous research governance” is a must.

ESG back and forth

It’s hard to keep up with all of the ESG-related political rhetoric, but there have been some notable developments of late.  Liz Hoffman provides a short summary for Semafor in “The backlash to the ESG backlash is here.”  The question of whether the exercise of fiduciary duty should be scripted by politicians is likely to go on for some time.

Interestingly, Rob Kozlowski of Pensions & Investments reported that the announcement of the search for a new chief investment officer in Florida “lacks any description of the responsibilities of the position or required qualifications of candidates interested in taking it on.”  Given the “anti-woke” stance taken by Governor DeSantis, there may be at least one requirement.

Creating value with others

A paper from David Koenig is titled “Nested Freedom: The surprising and complex intersection of risk, risk perceptions, and an organization’s ability to create value,” and it concerns corporate governance and the responsibilities of boards of directors.  The ideas included also apply to organizations in our industry, and to subsets of them such as investment committees and teams.

Fees

On Twitter, Christine Benz asked:

Discuss:  Are higher expense ratios on stock mutual funds v. bond funds largely a convention of the industry?  Or is it actually that much more costly to run a stock fund than a bond fund?

Those are good questions and the comment threads offer a variety of explanations and perspectives.  What do you think accounts for the differences?

Other reads

“Swan lake: the risks that would most disrupt consensus in 2023,” New York Life Investments.  Part of risk management is considering “not only the upside and downside scenarios to our base case views, but also black swans.”

“Major brokerages and news media feature technical analysis,” David Bailey, Mathematical Investor.

Given that “trends,” “waves,” “breakout patterns,” “triangle patterns,” “shoulders” and “Fibonacci ratios” make no sense in climatology or cardiology, why should one pay any attention to them at all in finance, much less base one’s life savings or other investments on such dubious reckonings?

“Private Equity Has Met the Enemy . . .” Herb Greenberg, LinkedIn.  “Private equity is stuck, unable to flip these things to someone willing to pay even more.”

“Commodity investing and its role in a portfolio,” Anatoly Shtekhman, et. al, Vanguard.  This primer “demystifies commodity investing by taking a deep dive into its returns, diversification benefit, and link to inflation.”

“Can ChatGPT Help Win Mandates? PanAgora Wants to Find Out.” Michael Thrasher, Institutional Investor.

While the technology is still in its infancy, it’s probably a good bet that other asset management companies will follow PanAgora’s lead, and not just to ease the laborious process of completing RFPs.

“Is There a Need for a Chief Liquidity Officer?” Michelle Teng, PGIM.  The specific liquidity demands of different kinds of investors would be better addressed individually or in a longer piece, but the general point is well taken.

“Green Bonds, Empty Promises,” Quinn Curtis, et al, SSRN.

Green bonds often make vague commitments, exclude failures to live up to those commitments from default events, and disclaim an obligation to perform in other parts of the document.

”To Be Frank,” Chenmark.  “Some thoughts on diligence” in light of JP Morgan’s embarrassing purchase of Frank, even if it just amounts to “an annoying PR debacle and a small write-off” for the behemoth.

“Big banks ignore risks and keep upping private markets investments.” Selin Bucak and Margaryta Kirakosian, Citywire Global Private Banker.  A look at how alternatives are being used at some notable providers of private wealth management services.

“Great resignation hits DC plan committees,” Margarida Correia, Pensions & Investments.

More plan sponsors are reporting high turnover in retirement plan committees, losses that industry observers say have sent some plan sponsors scrambling to find new members and get them up to speed on their fiduciary responsibilities.

“The detailed, subjective ranking of research note graphic design you’ve always wanted,” Louis Ashworth, Financial Times.  Most sell-side research reports look like each other, but this posting focuses on their relative aesthetics.  More importantly, how would you reinvent the form of research reports to be more useful?

The play’s the thing

“These heroes of finance are like beads on a string; when one slips off, all the rest follow.” — Henrik Ibsen (1828-1906)

The conveyor belt

A core tenant of The Investment Ecosystem is the inexorable change that occurs over time across every dimension (except human behavior).  One aspect of that is nicely visualized by Brett McDonald in a posting on his site, Paper & Blocks.  What is “emerging” today may someday become “traditional,” turning early adopters into big winners.  Organizations need to choose where along the belt they want to place their bets.

Postings

Two pieces have been distributed of late:

“Cliques and Claques in the Ecosystem.”  This is a reposting of an earlier piece, not in front of the paywall, exploring how the disciplines of sociology and anthropology are essential to understanding both asset pricing and how organizations operate.

“Letters from the Ecosystem.”  In this posting for paid subscribers, communications from MITIMCo, Permanent Equity, Jefferies, and Lindsell Train offer examples and lessons about conveying messages to clients and stakeholders.

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.

Published: February 27, 2023

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Four for Friday ~ Letters from the Ecosystem

Messages from investment professionals and organizations traverse the ecosystem with regularity.  Some types of communication have been around for decades — think of the updates of mutual funds or separate account managers that used to arrive in the mail — while other forms and forums are relatively new.  The ease with which views can be spread electronically, including on social media, has caused an explosion in activity.

Instead of a comprehensive view of the standard approaches — and the risks and opportunities involved — here are four examples from disparate organizations.

MITIMCo

Most communications from asset owners are internal (to governing boards, etc.), although government pension funds may be required to share information more broadly.  Some other entities do it voluntarily by sending reports to stakeholders or by making them public (with varying degrees of transparency regarding strategies and methods).

In one sense, the 2022 letter from the MIT Investment Management Company was celebratory, marking the fifteenth year that the current leadership has been in place managing the endowment and its enviable record of return.  But the letter focuses on the challenges involved in the investment process and the “forces that make it very hard for anyone to generate compelling returns over long stretches of time.”  As a result, MITIMCo tries to do some things differently than others; its manager selection, its team structure, and its Cambridge real estate program are highlighted as areas in which that is the case.

Other topics include an exposition of some of the organization’s mistakes and its preparations for the inevitable downturns that occur.  (The 2023 letter, due in a month, will no doubt deal with how that all worked out.)

MITIMCo also has a site with lots of information for and about emerging managers, a good example of an uncommon tactic.

Permanent Equity

The latest annual report from Permanent Equity also looked back over fifteen years — “in the trenches.”  It buys and operates businesses with annual owner earnings of up to $25 million. Unlike a typical private equity fund it “has no active intent to sell,” with fund lengths of almost thirty years and the opportunity to extend beyond that.

Much of the report, written by founder and CEO Brent Beshore, is personal in nature (and, again, forthcoming about mistakes).  Reading it, you come to understand the character and ethos of the organization.  Results are mentioned briefly and new employees and investments are introduced, but most of what is covered concerns the philosophy of the firm and its reasons for being.

Permanent Equity also has done a great job with newsletters.  An October Fortnightly cited the “Permanently Playbook” updates as featuring “original content and helpful links to other sources, all presented in an engaging way.”  In addition, president and CIO Tim Hanson started writing “Unqualified Opinions” this week and they have been great so far.

Jefferies

Monthly “Leadership Letters” come from Rich Handler and Brian Friedman of Jefferies, “a leading global, full-service investment banking and capital markets firm.”  There are 117 of them available online, an example of the value of an archive of materials for those who want to see how the focus of an organization changes over time.

The most recent edition, “People and Purpose,” recounts the big questions at the firm at various times:  in the late 1980s, ten years later, in the midst of some crises in 2011, and during 2020, the year of Covid.  It closes with a look at the priorities of today mentioned in the title, including these points (among others) in the people section:

The “eat what you kill” mentality no longer exists at Jefferies.  It doesn’t mean we have lost even one drop of our entrepreneurial spirit.  It just means we think bigger, broader and for longer as we build our careers and our firm.

It is pretty clear that too many firms don’t prioritize their people the way they should.  This is a HUGE opportunity for us.  We can be The Wall Street Firm that is HUMAN.  This doesn’t mean we are immune from making the tough decisions that always permeate our industry, but how we make those decisions can and will define us.

In the culture of Wall Street, those are notable and difficult goals.

Lindsell Train

A November thought piece from James Bullock of Lindsell Train is an example of a longer-form exploration of an underpinning of a manager’s investment philosophy.

It tries to square “the disruptive backdrop of enormous industrial and technological change” with Lindsell Train’s goal of investing in “rare, exceptional companies;” more than half of its holdings are in companies that are over a hundred years old.

Three ways of thinking about the survivability of companies are described, each plotted in graphs which are included in the piece.  They inform the judgment that “the longer something has endured, the longer it is likely to go on enduring,” that the act of survival “itself is a demonstration of survivability.”  Despite that, “there seems to be little if any evidence of a survivability premium” in the valuation of firms in the marketplace.

We all “talk our book.”  Good communication goes beyond that to offer ideas worth pondering and portals into underlying beliefs and goals.

Published: February 17, 2023

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Causal Factor Investing, Created Value Attribution, and Numbers That Lie

After a few weeks off, The Fortnightly is back, offering interesting readings from around the ecosystem.  There’s something for everyone.

For the full slate of content, consider a paid subscription (now available at reduced prices).  Check the archives to see what you’re missing.  If you see a posting you’d like to read, send a note to that effect and you’ll get a PDF of it in return.

Causal factor investing

“Virtually all journal articles in the factor investing literature make associational claims, instead of causal claims.”  Thus begins the abstract for an intriguing paper by Marcos Lopez de Prado, “Causal Factor Investing: Can Factor Investing Become Scientific?”  It lays out the “spurious claims” that serve as theoretical support for much of the factor investing that has become prominent across the years.

The author posits that researchers (and firms that offer products based on their research) encourage conclusions that aren’t supported by their methods:

The practical implication of this logical inconsistency is that the factor investing literature remains at a pre-scientific, phenomenological stage, where spurious claims of investment factors are accepted without challenge.  Put simply:  without a causal mechanism, there is no investment theory; without investment theory, there is no falsification; without falsification, investing cannot be scientific.

This does not mean that investment factors do not exist, however it means that the empirical evidence presented by factor researchers is insufficient and flawed by scientific standards.

In the industry, “commercial asset managers require investors to accept disclaimers such as ‘past performance is not indicative of future results’ in direct contradiction with the inductive claims that authors promote and managers sell to customers.”

While the paper as a whole might be a challenge for those who don’t specialize in quantitative analysis, you can skip the details and still see that some widespread assumptions that drive investment practice deserve greater scrutiny.  (A slide deck on the topics is also available.)

Created value attribution

Kroll has published a report, “Created Value Attribution,” which goes beyond the standard “value bridge” of private equity analysis, in an attempt to deal with what it doesn’t demonstrate:

Investments with strong returns are sometimes just the result of timing and market movements, and sometimes weak investment returns hide value creation or value preservation in difficult environments.

By expanding on the current approach, a whole range of possibilities become evident.  A series of graphics accompanies the explanations that are provided, showing how the analysis builds.  (Figure 3 includes an error in the investment value at valuation date that might throw you off; all of the rest of the images foot with the original value bridge.)  The adjustments make evident changes in revenue, margins, cost of capital, growth, and balance sheet items; show clearly the changes in the components due to acquisitions; and put the information in the context of industry and capital market developments and deleveraging actions, all of those adjustments ultimately resulting in something Kroll calls “unique” (think alpha).

It is more work, to be sure, but the breakdown offers insights not available from the current blunt instrument.

The numbers lie

You might not expect an article in the Harvard Business Review carrying the title “How Financial Accounting Screws Up HR” to be of much interest, but it is worth your time.  In the United States, rules prevent the sensible accounting treatment of investments in human capital, causing company managers to make poor long-term decisions and inhibiting analysts from understanding which firms are investing in ways that will pay off over time.  The examples provided — and the questions asked — are thought-provoking.

Other reads

“Submergence = Drawdown Plus Recovery,” Dane Rook, et. al, SSRN.

Smart diversification is a potent weapon against drawdown risk.  Yet appropriate diversification strategies should be rooted in reducing the overlap between the depth and duration of drawdowns (and recoveries) of assets in a portfolio, rather than fixating on lessening the correlation between asset returns (which is the usual emphasis of diversification).

“The Best Stock Research Tools for 2023,” Edwin Dorsey, The Bear Cave.  An eclectic set of sources; a few common ones, but many below the radar, including websites, podcasts, newsletters, presentations, etc.

“The Path to Inclusive Capitalism,” Blair Smith, et. al, Milken Institute.

As the ultimate owners of capital, asset owners have the ability and responsibility to drive DEI within investment management teams and portfolios and across the asset management industry.

“Disruptive Innovations IX,” Citi.  Ten things to “stop and think about,” including a section on professional qualifications, credentialing, and learning — all issues in the investment world.

“Infrastructure investing will never be the same,” Marcel Brinkman and Vijay Sarma, McKinsey.

Revolutions in energy, mobility, and digitization are introducing new dynamics to existing infrastructure investments that previously appeared almost impervious to change.

“Investing Novices Are Calling the Shots for $4 Trillion at US Pensions,” Neil Weinberg, Bloomberg.  Not the Canadian Model.

“Choosing Pension Fund Investment Consultants,” Aleksandar Andonov, et. al, SSRN.  “Overall, our evidence is consistent with pension funds hiring consultants to shift responsibility rather than improve performance.”

“The Illusion of Trust in Asset Management,” Angelo Calvello, Institutional Investor.

If you want institutional money, or if you are a steward of institutional money, you should be willing to accept the most invasive due diligence on the planet . . . . But [allocators] may not do it because the tough questions make them worried they’ll be seen as dumb or rude.

“Asset Management: The Year That Was,” Harriet Agnew, Financial Times.  A look at 2022 through stories and links, a number of which were best followed by the FT.

“Kuhnian thinking and investments,” Mark Rzepczynski, Disciplined Systematic Global Macro Views.  “The old paradigm does not work and cannot explain the facts, so a new paradigm has to take hold and replace the old.”

“Short-term vs Long-term,” Nick Sleep, The I.G.Y. Foundation.

The list is not exclusive (outputs and inputs are often inter-changeable) or exhaustive, but it may be the start of a map away from the worst moat-draining activities and behaviours and toward a more rational and fruitful allocation of time and resources.

“Did Investor Interest In Financial Reporting Peak With Enron?,” Shivaram Rajgopal, Forbes.  “Who reads a 10-K anymore?”

“Should We Listen to Outperforming Fund Managers?” Joe Wiggins, Behavioural Investment.

If a fund manager has a strong track record we listen with rapt attention to everything they say about anything.  If their returns are poor, we disregard their words.  This may sound sensible but it is anything but.

“My 8 Best Techniques for Evaluating Character,” Ted Gioia, The Honest Broker.  Great ideas for the difficult business of understanding others, a critical skill in the investment world.

A storm coming to venture?

“So LPs are looking at a world of inflated fund sizes, bloated teams, very high fees/carry, and very little actual deployment in good new companies over the past 12 months.  They also know that TVPIs are super inflated, gross DPIs are going to be awful, and net DPIs even worse.”  — From a Twitter thread by Gil Dibner.

Capital allocation  In the introduction to “Capital Allocation: Results, Analysis, and Assessment,” Michael Mauboussin and Dan Callahan cite the research that supports this chart, writing that “the vast majority of companies could improve their financial performance by increasing their reallocation [of capital].”

The report covers the sources and uses of capital, alternatives for the allocation of it, and ways to assess management’s capital allocation skills (including a checklist in that regard).  A large number of exhibits are provided.

As was highlighted in the HBR article referenced earlier, not having information available to assess the allocation of human capital as part of an exercise like this is a major shortcoming for analysts.

Postings

Two pieces have been distributed since the break in the action:

“Airbrushed Appearances and Underlying Realities.”  Due diligence encounters are dominated by impression management.  Those doing the work need to be skeptical and employ tactics that will go past the narrative to add value.

“The Pull of Reciprocity in Decision Making.”  From trivial swag to fancy perks, the investment business is full of favors and gifts.  How do they affect what decisions we make?

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.

Published: February 13, 2023

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Airbrushed Appearances and Underlying Realities

Dealing with due diligence analysts and capital allocators is a series of performative acts for asset managers.

It would be naïve to think it could be otherwise.  As humans, we spend a great deal of time on impression management.  (Organizations are no different.)  We all want our story to be told by others in the way that we would tell it ourselves.

Above all, superior due diligence requires skepticism about those stories and the application of techniques to distinguish narrative from reality.

Where the lines are drawn

Any aspect of an organization or individual can be airbrushed for presentation to the outside world.  The overall pattern of that activity can be informative, including where it seems to be most prevalent (from whom and regarding what things) and the general levels of promotion versus openness that exist.

Policies regarding transparency are revealing, whether they concern the details of investment process and methods, whom you can talk to and whom you can’t, what kind of information is willingly shared, or any number of other things.  Sometimes those boundaries are drawn for good reasons, but a line can be placed where it is in order to obscure the mess on the other side of it.  (Foundational principle:  “All organizations are messy.”)

Angles

There are a variety of tactics that can be used to crack the narrative.

One simple but powerful method is to get people to talk about the areas of the organization and its investment approach that need improvement.  Often they struggle with the question, since they don’t want to admit any shortcomings.  (Those in charge and more practiced in the narrative frequently do worse than junior people, who see how the sausage gets made and may not be as guarded in talking about it.)  Open discussion about the challenges that exist is a good sign in an organization; bluster and defensiveness are bad ones.

Talking to a number of people separately is preferable to group meetings.  While it can sometimes be enlightening to see how an investment team reacts to each other, most of what you’ll see when they are together is theater.

A 2018 posting listed some of the lessons for investment organizations (and those who analyze them) that came from studying the missteps of the “best and brightest” who led the United States involvement in the Vietnam War.  One telling incident, very early on when there were only U.S. advisors and not soldiers in the country, happened when Bobby Kennedy asked an assembled group of them what problems they faced:

None would admit to there being any.  When he then invited them to talk to him one by one, it all came spilling out, “a brief and instructive lesson in what people would say for the record and what they would say in private.”

The need to hew to the narrative (and to practice organizational, as opposed to personal, impression management) is especially powerful when you are gathered with your tribe and meeting with others from the outside.

Another way to spot topics that might be worth prying open is by comparing messages across communication channels (websites, regulatory filings, monthly updates, DDQs, white papers, etc.).  Sometimes they are out of sync with each other, even in small ways, providing clues that are open to all.  Historical comparisons of those sources can also be revealing, highlighting the advantages of having a good historical record (of your notes and reports too) that can provide fodder for investigation.

Value added

Just as alpha is delivered by asset managers who are willing to be different, discovery during due diligence comes from unusual game plans rather than common ones.

Can the slicing and dicing of performance numbers every which way provide some insight?  Rarely.  Can holdings information give you fodder for good questions?  Sometimes, but it’s often the small investments a manager has made that can give you the most interesting hints (while everyone else is focused on the top ten).

Given that time in interview meetings is precious, how it is spent is critical.  Large chunks are usually devoted to the discussion of investment ideas, which seems reasonable on the surface, but gets you into the realm of manager storytelling.  Unless your questions are better than those of everyone else who asks them, you might not learn much of value (even as you are more vulnerable to attempts at impression management).

It’s better to look for wedge issues that aren’t often on the table in those kinds of meetings.  Take the topic of culture for example.  It is discussed superficially if at all (and recounted in analyst reports in superficial fashion).  If the ability to analyze culture in depth is part of your toolkit, you can understand the organization in ways that others can’t (and you have an advantage over those you interview, who may talk about culture but have little real knowledge about the relevant principles involved).

Similarly, there are methods to evaluate investment process that go beyond the narrative that is provided to you.  Taking that path is much more fruitful that finding out what someone thinks about a particular investment.

Given that asset management is a people business, you might consider understanding the individuals on whom you will most rely to be the holy grail of the research process.  To do that well requires different skills and interview techniques — and the willingness to use them even when the subjects of your review are trying to resist your unusual ways so that they can paint an image of themselves for your consumption.

A conventional due diligence process allows asset managers to deliver their intended message as they would like.  Discovery involves getting past that.

All of these ideas about cracking the narrative (and many more) are explored in greater depth in the online course, “Advanced Due Diligence and Manager Selection,” and in customized training sessions that are provided to organizations.

Published: February 11, 2023

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The Pull of Reciprocity in Decision Making

We all like to think that we make choices in an objective manner, but we are human after all, and the influences of others and our own biases affect how we make decisions.  Reciprocity is a particularly interesting dynamic, especially given how business gets done in the investment world.

Cialdini’s principles

Robert Cialdini wrote Influence: The Psychology of Persuasion almost forty years ago.  In it, he outlined the six principles that are used by influence businesses (reciprocation, liking, social proof, authority, scarcity, and consistency), subsequently adding a seventh — unity.

In his 2016 book, Pre-Suasion, he opened the section on reciprocation with this simple statement:  “People say yes to those they owe.”  Even modest gifts can create a subconscious social debt, which is why mailed solicitations from charities often include items that you can use, Costco and others offer free samples, and time-share companies allow you to enjoy a deeply-discounted stay before you hear the sales pitch.

Munger on misjudgment

Charlie Munger addressed reciprocation in his speech, “The Psychology of Human Misjudgment,” using “reciprocate-favor” to differentiate the kind of activity we’re focusing on here from its flip side, which involves retaliation:

Like other psychological tendencies, and also man’s ability to turn somersaults, reciprocate-favor tendency operates to a very considerable degree at a subconscious level.  This helps make the tendency a strong force that can sometimes be used by some men to mislead others, which happens all the time.

Wise employers, therefore, try to oppose reciprocate-favor tendencies of employees engaged in purchasing.  The simplest antidote works best:  Don’t let them accept any favors from vendors.  Sam Walton agreed with this idea of absolute prohibition.  He wouldn’t let purchasing agents accept so much as a hot dog from a vendor.

Industry examples

As a participant in the investment world, you are on one or the other side of reciprocate-favor situations, depending on whether you are selling or buying products and services.  Given that chains of agents are found throughout the business, you may very well be on both sides at different times.  For example, an investment advisor may be the recipient of favors from a mutual fund company as well as the provider of favors to prospective clients.

An excellent exposition of the wooing that goes on in the industry can be found in Karen Ho’s book, Liquidated: An Ethnography of Wall Street.  One section details the recruiting of potential investment bankers from Ivy League schools, which starts with the offering of pretty mundane items:

They hand out the best goodie bags, the most titillating magnet sets, mugs, Frisbees, water bottles, caps, and t-shirts, and in a matter of days, thousands of students become walking advertisements as their logos disperse into campus life.

As the process continues, there are gatherings with free food and drinks.  Eventually, when the pool of candidates is winnowed down, there are nights at hotels in New York City, meals at fancy restaurants, and events to make them feel even more special than they already do.

Those that are selected may someday — after their grueling apprenticeships — be senior investment bankers themselves, practiced in the art of schmoozing and providing favors (along with doing the other parts of their jobs).

Jason Zweig wrote of the little gifts common in the industry in a 2012 holiday season piece, “The Big Corruption in Small Gifts”:

Giveaways, gifts, freebies, premiums, promos, tchotchkes, swag.  Every year around this time, it pours in:  the pens with corporate logos, the canisters of flavored popcorn, the iTunes gift cards, the boxes of chocolate, the pocket calendars, the shipments of fresh fruit.

No one is really affected by that stuff, right?  On the contrary, the impact is greater than you might expect.  The fund companies that stuff their booths at conferences with branded goodies wouldn’t spend “all that money on swag in the first place unless they thought it would sway the financial advisers who took it.”  At a minimum, they are creating walking advertisements at those conferences (just like the investment bank recruiters do), and the artifacts find their way back to advisory firm offices as continual reminders.

Escalation

The bigger the pile of money at stake, the more things can get out of control in the favor-giving department.  One place where that has happened is in dealings between large money managers and the brokers that seek to do (more and more) business with them.

The culture of those relationships has historically involved lots of entertaining, from expensive dinners to prime seats at concerts and sporting events.  And golf at top courses, begging the question, “What consideration should be given to an institutional salesman’s firm when he takes you to Pine Valley for a couple of rounds each year?”

Over time, it’s easy for the offers to escalate (or, brazenly, for the asks to escalate).  Not that you start with a large tin of Virginia peanuts at Christmas and then one day it’s private jets to Las Vegas with “hookers and blow,” but it has been known to get that out of hand.

Compliance

While there is guidance from regulators regarding gift-giving practices (for example, in the United States, from the SEC and FINRA), there is quite a bit of latitude in interpretation.  Organizations need to formulate and enforce compliance rules on their own.

Therefore, gift-giving and gift-receiving expectations should be clear to all.  And since owners, leaders, and star players in an organization are the ones most likely to offer or receive extravagant gifts and favors, it’s important that they be held accountable just like everyone else.

Favors are powerful and reciprocity is a foundational aspect of human interaction.  Our decisions can be affected in ways that we don’t understand.

Published: February 7, 2023

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Gaslighting, Chatting with Machines, and the Biggest Change in Forty Years

Announcement

The Investment Ecosystem will be on hiatus for six weeks for some time off and some retooling.  Paid subscribers will have the due dates for their next payments pushed back two months.

Have a great holiday season and start to 2023.  Thanks for reading.

Sea change

Howard Marks produced one of his legendary memos, about what he sees as the third sea change in the markets during his long career.  The other two happened more than forty years ago — “the advent of risk/return thinking” and the relentless decline in interest rates.

Towards the end of the essay, he included a table showing the change in fourteen market attributes during the last year.  It is a framework that can be used for discussing investment beliefs and implications.  If we really are facing “a complete reversal of the conditions” that have animated the investment environment for decades, then there is a need for reassessments that go well beyond the normal projections so common this time of year.

Growth and value

Acadian produced a paper on “Growth Versus Value: End of an Era?”  The summary points:

Prevalent narratives trumpeting value’s resurgence in 2022 are muddled by the increasing irrelevance of mainstream value benchmarks.

Nevertheless, a nuanced examination reveals that the 2022 value revival is best interpreted as the reversal of a historically unprecedented run of speculation in growthy assets over the prior five years.

In an investing world anchored to 1, 3, 5, and 10-year track records, investors face a broad challenge in framing expectations going forward now that economic and policy conditions have shifted away from those that fostered a “one-factor bet on growth.”

The piece includes a number of interesting charts, as does GMO’s third quarter letter, which announces that “after a good run, value looks anything but exhausted.”  Especially deep value.

Gaslighting

A recent edition of Bob Seawright’s The Better Letter covers “Financial Gaslighting,” specifically related to hedge fund marketing.  If you’ve been around a while, this progression will be familiar to you:

Gaslighting and poor performance undergird the change in hedge fund marketing over the years.  It went from “We’re going to make a ton of money,” to “We’re going to outperform,” to “We’re going to provide superior risk-adjusted returns,” to “We’re going to provide absolute returns even in down markets,” to “We’re going to provide non-correlated returns.”

ChatGPT

One of the most notable events of late has been the introduction of ChatGPT (and the attention it has drawn).  More to come on that front in a few weeks.  For now, here’s an article from Robin Wigglesworth of FT Alphaville on “ChatGPT vs The Sellside.”  (“ChatGPT can probably already write the routine earnings preview and review as well as many sellside analysts.”)

Other reads

“Should Your Portfolio Protection Work Fast or Slow?” AQR.

Most importantly, drawdowns like the current one, in which adverse conditions impact public and private investment strategies in a persistent way, are the most damaging to investor portfolios — so they should matter the most when identifying strategies intended to improve a portfolio’s resilience.

“Lessons from FTX: The Cost of Ignoring ODD,” Castle Hall.  The latest chapter of a long-running story.

“Portfolio Implications of a Positive Stock-Bond Correlation World,” Noah Weisberger and Xiang Xu, PGIM.

Shifting to a positive stock-bond correlation world will cause a balanced portfolio of stocks and bonds to deliver more volatile performance with a wider set of potential long-term outcomes — including more extreme tail events and deeper max drawdowns.

“Ideas That Changed My Life,” Morgan Housel, Collaborative Fund — and “Some Thoughts About Investing,” Ben Carlson, A Wealth of Common Sense.  Concepts worth pondering.

“The Lies We Tell Ourselves About Startup Valuations, Scott Lenet, Touchdown Ventures (via CAIA Association).  And some truths too:

Do your own work.

The last round is over, so price the new round independently.

It’s not your obligation to provide the startup with the amount of money they’ve requested.

“School of Quant: At $29,000, a Public NYC College Outclasses Princeton,” Heather Perlberg, Bloomberg.  Baruch College is “Quant U.”

“Three Ideas I Wish I Had Understood From the Start,” Trevor Graham, TIFF.

Creativity is vitally important — and often underappreciated.

Being open-minded is more important than being smart.

A steady temperament might be the most important characteristic of all.

“Annual RIA M&A Outlook,” DeVoe.  “The expectations are the lowest in the survey’s history.”

“Basic Interview Tips,” Frank Travers, LinkedIn.

Know when to be quiet (which should be most of the time if you are the interviewer).  Ask your question, and then stop talking!  This is a skill that very few people seem to be able to master.  In addition, I have found that people generally are uncomfortable with silence and tend to keep talking (which can lead to new and interesting tidbits of information).

“When the Tech Revolution Came to Wall Street,” Marty Fridson, Stories.Finance.  How technology has changed investing over the decades.

“Diversity Washing,” Andrew Baker, et. al, SSRN.

We document significant discrepancies between companies’ disclosed commitments and their hiring practices and classify firms that discuss diversity more than their actual employee gender and racial diversity warrants as “diversity washers.”

“International Private Equity and Venture Capital Valuation Guidelines,” IPEV.  On your marks . . .

Limits

“Every person takes the limits of their own field of vision for the limits of the world.” — Arthur Schopenhauer

ESG

A year ago, ESG was hot.  Now it’s a hot potato.

The Callan 2022 ESG Survey includes the above graphic.  The blog summary regarding the survey says of the decline, “This can be attributed in large part to a significant drop in the share of public plans incorporating ESG, likely due to a shift in the respondents to this year’s survey.”  Whatever the reason, the change is evident.

Meanwhile, “BlackRock Is Caught in the ESG Crossfire and Struggling to Get Out.”  It’s not hurting yet though:  “BlackRock has pulled in much more money from US retail investors than its rivals so far in 2022, even as the world’s largest asset manager has come under attack from both the left and right over its approach to sustainable investing.”

Postings

“To CFA Institute: Don’t Forget History” is available to all on LinkedIn.  It details disappointing changes in the availability of content from the organization.  (Also see David Merkel’s posting, “The Value of a CFA Charter: Ethics.”)

Two postings for paid subscribers:

“Essential Elements in External Networks.”  Typically, most of the ideas that drive the performance of an investment function are shaped by interactions with others outside of the organization.  How do we improve them?

“Dimensions of Learning for Investment Professionals.”  What types of knowledge are important for investment professionals?  How should they be trained?  Alix Pasquet offers some thoughtful and differentiated ideas.

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.

Published: December 19, 2022

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